IRS Issues Proposed Regulations on Payroll Tax Liability of PEOs and Other Third-Party Payors

February 21, 2013
Joshua R. Welsh and Joshua L. Cannon

The IRS recently issued proposed regulations that could potentially increase the circumstances in which Professional Employer Organizations, Employee Leasing Companies and other Third-Party Payors could be held liable for unpaid employment taxes.

Proposed Regulation §31.3504-2

On January 29, 2013, the IRS issued proposed regulations under Section 3504 of the Internal Revenue Code (the “Code”) regarding the “Designation of Payor as Agent to Perform Acts Required of an Employer.”  These proposed regulations would extend a third-party payor’s liability for unpaid payroll taxes to, subject to certain exceptions, circumstances in which the third-party payor has entered into an agreement with an employer under which the payor “performs the employment tax obligations of the client with regard to wages or compensation paid by the payor to individuals performing services for the client,” even if certain other existing requirements for imposing such liability have not been met.

The proposed regulations would effectively extend the current law, under which a payor generally is only liable if it is: (1) deemed to be a common law employer (i.e.,  the payor generally has the right to control and direct the work performed by the employee); (2) deemed to be a Code Section 3401(d)(1) employer (i.e., the payor generally controls the wages paid to the employee); or (3) appointed as a Section 3504 agent (i.e., the payor and the employer for whom the payor is acting submit IRS Form 2678, “Employer/Payer Appointment of Agent”).

Background

Employment (Payroll) Taxes

Under the Federal Insurance Contributions Act (FICA), employers generally must withhold 6.2% of an employee’s wages, up to the then-applicable wage base ($113,700 for 2013) which is then contributed to Social Security. Employers are also separately liable for the employer share for Social Security of 6.2% of the employee’s wages, again up to the then-applicable wage base.  Likewise, employers are required to withhold 1.45% of an employee’s wages for Medicare and are separately liable for the employer share of 1.45%.  There is no wage base for Medicare, so all of an employee’s wages are subject to Medicare tax.  Under the American Taxpayer Relief Act of 2012, the employee share of the Medicare tax increases for 2013 and subsequent years by 0.9%, to a total of 2.35%, for employees whose wages exceed $200,000 for single filers and $250,000 for joint filers.

Under the Federal Unemployment Tax Act (FUTA), employers generally are responsible for paying an amount equal to 6.0% of an employee’s wages.  The wage base for FUTA is $7,000, and a credit is given for state unemployment tax paid, of up to 5.4%.  Thus, an employer’s net FUTA tax rate may be as little as 0.6%.

In addition to FICA and FUTA, employers are generally required to deduct and withhold federal income tax from their employee’s wages.

Tax Return Reporting and Filing Obligations

In connection with the deduction, withholding and payment requirements set forth above, employers are generally required to make periodic tax filings.  FICA wages are reported to the IRS quarterly on Form 941, Employer’s Quarterly Federal Tax Return.  FUTA wages are reported to the IRS annually on Form 940, Employer’s Annual Federal Unemployment Tax Return.  Note, however, that, with limited exceptions, Section 3504 agents, which are the subject of this discussion, are not, according to the preamble to the proposed regulations, “authorized to perform the employment tax obligations of an employer with respect to the FUTA tax” and, consequently, “an employer generally must continue to satisfy its FUTA tax obligations by filing a Form 940 using its own EIN.” Withheld federal income tax is reported to the IRS annually on Form 945, Annual Return of Withheld Federal Income Tax.

Liability for Employment/Withheld Income Taxes

As common sense would dictate, an employer (or, as relevant to these discussions, the employer’s agent) is responsible for paying over to the government all of the taxes that it withholds from its employees’ wages (in addition to the FICA and FUTA taxes which it separately owes).  This is important. When an employer withholds taxes it is deemed to be holding those funds in trust for the government.  When an employer fails to pay these “trust fund” taxes over to the government, the payor’s owners and other “responsible persons” can be held personally liable for all outstanding amounts.

Third-Party Payor Arrangements

Payroll obligations can be burdensome on small and even medium-sized businesses.  Accordingly, employers often turn to third-party payor arrangements in order to relieve these burdens.  These arrangements take on various forms, including payroll service providers (PSPs), employee leasing companies (ELCs), and professional employer organizations (PEOs).  PSPs, which are addressed in the preamble to the proposed regulations, typically enter into an agreement whereby they undertake to prepare employment tax returns and process withholding, deposit and payment of taxes, all using the employer’s EIN.  Under such arrangements, the PSP is neither an employer under common law or under Section 3401(d), nor an agent under Section 3504, and is therefore not ultimately liable for payroll taxes.  True ELCs, on the other hand, which hire the employee and temporarily place him or her with a company, are generally responsible for payroll tax liability as either such employees’ common law employer or as a Section 3401(d) employer.  PEOs are a bit trickier (since they have characteristics of both PSPs and ELCs) and are the most likely to be impacted by the proposed regulations.

PEOs will typically enter into an agreement with an employer-client to employ or co-employ that employer’s employees. The PEO will handle all of the client’s payroll issues, including the payment of wages, filing of employment tax returns, etc.  The co-employment relationship is important inasmuch as it generally allows a PEO to provide the employer-client with a better benefit package, including group insurance, qualified retirement plans, etc., while at the same time allowing the employer-client to control workplace and similar issues directly affecting the employees.

Registration requirements and law governing PEOs in Wisconsin are primarily set forth in Chapter 461 of the Wisconsin statutes.  Specifically, a PEO in Wisconsin “means a person that is engaged in the business of entering into written contracts for the provision of nontemporary, ongoing employee workforce of a client and providing services under those contracts and that under those contracts has the obligation to pay the employees providing services for those clients from its own accounts.”  Wis. Stat. §461.01(5).  Worker’s Compensation issues for PEOs are addressed in Wis. Stat. §102.315.  Unemployment Insurance issues for PEOs are generally addressed in Wis. Stat. §§ 108.02(21c), 108.065(2)(b) and 108.067.

Implication of the Proposed Regulations for PEOs

Essentially, the proposed regulations would add a new category of circumstances in which a third-party payor can be targeted by the IRS for payroll tax liability.  This may impact certain PEOs.  Currently, PEOs can knowingly assume liability for payroll taxes by submitting, along with the client, Form 2678 to the IRS.  Under the proposed regulations, a payor could be deemed by the IRS to be an agent under Section 3504, and therefore subject to liability, even without submitting Form 2678, if it has entered into a “service agreement” with an employer to handle payroll tax obligations.  Specifically, under the proposed regulations, the “service agreement” at issue is one in which “the payor: (A) asserts it is the employer (or co-employer) of the individual(s) performing services for the client; (B) pays wages or compensation to the individual(s) for services the individual(s) perform for the client; and (C) assumes responsibility to collect, report, and pay, or assumes liability for, any taxes... with respect to the wages or compensation paid by the payor to the individual(s) preforming services for the client.”  Significantly, such a service agreement does not need to be in writing, and an oral agreement meeting the above elements will have the same effect.

Importantly, these rules do not take the employer-client completely off the hook.  When an employer appoints an agent, either by executing Form 2678 or by virtue of a service agreement as set forth in the proposed regulations, both the agent (PEO) and the employer are liable for the payroll taxes.

Conclusion

In many respects, the Proposed 3504 Regulations are straightforward.  They essentially apply a substance over form test by saying to PEOs:  “If you’re responsible for payroll taxes... well, then... you’re responsible for payroll taxes.”

Certainly, many PEOS, either in their standard contract or by virtue of negotiation with a client, will include a provision that requires the PEO to indemnify the client in the event of payroll tax liability attributable to the PEOs failure to collect or remit taxes.  It appears that the proposed regulations nevertheless provide some benefit to clients in such situations inasmuch as the IRS will now have authority to pursue the PEO directly in circumstances in which it may have otherwise pursued the employer-client, which would then have to incur costs pursuing its indemnification rights.




TAX ADVICE LIMITATION:  To ensure compliance with the requirements of Circular 230, we inform you that any tax advice contained above is not intended or written to be used and cannot be used (i) by any taxpayer for the purpose of avoiding penalties that may otherwise be imposed under the Internal Revenue Code or (ii) by anyone for the purpose of promoting, marketing or recommending to another party any entity, investment plan or arrangement addressed herein.